While some companies might have straightforward debt structures where all debt has an equal rank, there are those that issue debts with different rankings or levels of seniority. This ranking refers to the priority of payment, with the highest ranking or the most senior of these debts having the first claim on the assets and the cash flow of the issuer. Among the debts with the lowest rank is the subordinated debt.
Read on for everything you need to know about these debts.
Why rank debt?
You might be wondering why debts have a ranking in the first place. As long as all tranches of debt get paid the respective principal and interest payments owed, it’s all good, right? Well, the reason for ranking debt is that in business, sometimes things go wrong. For many businesses, the most wrong they can go is bankruptcy.
In case of bankruptcy, the most senior or the highest ranking debts get the priority when it comes to payment. Theoretically, these debts have a right to be paid first. As you can probably imagine, this ranking is critical when investors or lenders are looking to protect their own downside.
Companies understand this and that’s the reason they rank debt in terms of priority or seniority.
What is subordinated debt?
A subordinated debt is an unsecured loan or security that ranks below other loans or securities with regards to claims on assets or earnings of the issuer.
Should a company go bankrupt, for example, creditors with subordinated debt would not get paid until after other senior debt holders are paid in full. This is indeed the primary difference between subordinated debt and senior debt. Because senior debt has the priority of repayment, it carries lower risk and therefore has lower interest rates.
On the other hand, subordinated debts have a higher risk and therefore come with higher interest rates and consequently a higher expected rate of return for the creditor or lender.
While subordinated debt ranks behind senior debt, it has priority over equity holders and thus gets paid before them. This includes holders of both preference and ordinary shares.
Who offers and gets offered subordinated debt?
Typically, lenders understand that a subordinated debt comes with higher risk. Therefore, they are apprehensive about offering such debts to small businesses. In fact, many lenders such as banks will only offer senior debt or loans to small businesses.
The situation is, however, different for large corporations. These offer greater security for several reasons.
The first is that large corporations have huge cash flows and non-current assets that can allow lenders to be paid for subordinated debt. They also tend to have better solvency than small businesses. Additionally, the chances of big corporations going bankrupt are much smaller than those of small businesses.
In a nutshell, lenders are willing to offer subordinated debts to large corporations because they believe that the yield being offered is adequate compensation for the risk they perceive.
This is not to say that there are no exceptions. However, because of the risk factor, most lenders will not offer subordinated debt to small businesses.
As a result, subordinated debts tend to be mostly between financial institutions and large corporations that have a cordial relationship with one another.
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